Dodd-Frank: Past, Present, and Future

May 26, 2017

During the 2016 election and the following months, the Dodd-Frank Act received a lot of attention from Republicans and Democrats alike. While the parties disagree over the necessity of the Dodd-Frank Act, there is no doubt that it has strongly impacted the banking and financial services industry. As the act comes under fire from President Trump and Congressional Republicans, the main question now is whether this transformation is permanent, or as many current Republicans have promised, just a temporary blip in the history of banking regulations.

What is Dodd-Frank?

After every major financial crisis over the past century, policymakers have passed sweeping legislation to overhaul the way that banks operate. The Panic of 1907 prompted the Federal Reserve Act of 1913, which created our central bank. The Great Depression led to the Glass-Steagall Act of 1933, which established the Federal Deposit Insurance Corporation and prohibited the cohabitation of investment and commercial banks. In addition, the litany of crises throughout the 1970s and 1980s convinced Congress to broadly deregulate the bank industry through a series of broad reforms.

On July 21, 2010, President Barack Obama signed the Wall Street Reform and Consumer Protection Act, commonly known as the Dodd-Frank Act [1]. Written in the aftermath of the 2008 financial crisis, dubbed the Great Recession, the Dodd-Frank Act increased regulation and oversight of the financial system in order to avert future crises. To reduce repeated risk-taking and ensure stability, the drafters behind the Dodd-Frank Act wrote 2319 pages consisting of over 400 new rules and mandates. The Act increases bank reserve requirements, forcing banks to hold an additional cushion for loan losses in future downturns. It similarly mandates banks to keep a larger portion of their assets invested in options that can be easily liquidated in the event of a bank run – namely, cash and government securities as opposed to term loans.

The Act also subjects banks with large sums of investments to a series of heightened regulatory requirements that do not apply to regional and community banks. Every bank with more than $50 billion in assets on its balance sheet must submit to annual stress tests administered by the Federal Reserve to determine if they would survive a hypothetical severe crisis akin to the one in 2008. As a part of the stress tests, these banks must also seek regulatory approval to increase their dividends or authorize new share repurchase programs.

A chart detailing the complicated layers of oversight for the banking industry. Source: The Economist.

Another major provision is The Volcker Rule [2], which prohibits banks from engaging in certain types of speculative investments that do not benefit their customers, such as investing in hedge funds or private equity firms using their own funds. In addition, Dodd-Frank instituted the Consumer Financial Protection Bureau, which drafts regulations ensuring no banks become “too big to fail”;. This agency, along with heightened derivatives regulations and the Financial Stability Oversight Council, are designed to increase investors’ confidence, and limit the amount of risk that banks are allowed to carry.

Wins, Losses, and Uncertainties

Some of the regulatory measures have been more successful than others. In looking at potential revisions of Dodd-Frank, it is important to remember what has been successful, and what has not. Before the Great Recession, banks clearly held too little capital [3]. This capital was spent on loans to consumers. Once these consumers failed to repay their loans, banks were in trouble. Increased capital requirements have been a clear success of the Dodd-Frank Act. Another win comes in the creation of the Consumer Financial Protection Bureau (CFPB). This consolidated consumer protection to one single agency to create a level playing field between banks and consumers.

The Act has not been perfect, however. Dodd-Frank has eliminated the use of some regulatory tools in its restrictions on The Federal Reserve and Federal Deposit Insurance Corporation (FDIC). During the Great Recession, The Federal Reserve utilized emergency lending to ensure banks did not fail and ease investor concerns [4]. Similar to the Federal Reserve, the FDIC effectively used its Deposit Insurance Fund to aid the banking system by resolving failing banks.. Under Dodd-Frank, the Fed and the FDIC do not have the ability to step in and act decisively as they did in 2008 and 2009. Should there be another, there will be no authority with the power to act quickly and decisively to restore confidence and impose a comeback. These sections of Dodd-Frank can safely be considered a shortcoming, and certainly require an examination when making potential revisions.

While there have been some relatively clear successes and shortcomings, there have also been some uncertain tradeoffs. Some provisions in Dodd-Frank have achieved success, but at a substantial cost. Whether or not the tradeoffs are worth it cannot be known at this point, and both sides have different opinions of the rules. As previously noted, the Volcker Rule is very controversial, and falls into the costly tradeoff category. Proprietary trading was outlawed in Glass-Steagall, but those provisions were repealed in the 1980s and 1990s. Banks have argued that following the Volcker rule will make doing business more expensive and therefore hurt consumers. Its proponents argue that eliminating the risk that the proprietary trading posed to the economic system will be worth it.

Dodd-Frank has affected different individuals and groups in distinct ways. Democrats say that the financial system is more stable than it has been for a long time. Therefore, they claim that the average American citizen can be more confident that their investments and savings, and thus their financial futures, are safe. While there is no way to know for sure, it seems the added reserve requirements and the CFPB are two of the strongest pieces of Dodd-Frank and have almost certainly strengthened the stability of the United States’ financial system. Whether the costs of this strengthening outweigh the benefits remains to be seen.

Community banks' loan losses since the enactment of Dodd-Frank. Source: Forbes.

Critics of Dodd-Frank say that small community banks–banks with less than $1 billion in assets–have been adversely affected by the enactment of the bill. Due to the complex and at times convoluted portions of the legislation, banks have seen compliance costs rise substantially [5]. This has made business more difficult for small community banks, which make up 94% of all banks in the US [6]. While bulge-bracket banks can afford to have large compliance departments ensuring they are following the rules, community banks cannot. Due to the added costs, more community banks have consolidated with larger banks, exactly the opposite of what Dodd-Frank aimed to achieve. Almost all experts agree Dodd-Frank has been a success in some ways and failed in others. Whether or not the net effect of the bill is positive or negative depends on who you ask.

Policy Proposals

Executive

One of the prominent themes of President Donald Trump’s campaign was deregulation. He continually promised to eliminate regulations that he saw as restricting economic growth - specifically Dodd Frank. He took the first step towards following through on his commitments on February 3rd, when he issued an executive order instructing Steven Mnuchin, the Secretary of the Treasury, to assess if government policies promote or inhibit the core principles for financial regulation that the order specifies [7]. Though the order does not mention Dodd-Frank by name, President Trump made it clear that Dodd-Frank was the main target of the report. As executive orders cannot repeal Dodd-Frank, plans to more significantly limit its reach are most likely to come from Congress.

Legislative

On the whole, Democrats see Dodd-Frank as a success that has made America’s banking system much more stable. Republicans, on the other hand, think that Dodd-Frank is regulating banks more than necessary, making it difficult for banks to be profitable, and hindering overall economic growth.

One Republican plan to curtail Dodd-Frank is known as the Financial Choice Act. Introduced by Jeb Hensarling, the chairman of the U.S. House Financial Services Committee, the Choice Act would change Dodd-Frank by eliminating the Volcker Rule, doing away with stress tests, and decreasing the power of the CFPB [8]. Even though the Volcker Rule is unpopular with banks and Republicans, Democratic outgoing Federal Reserve governor Daniel Tarullo surprisingly said that he too is open to reforming the rule, but not repealing it [9].

Jeb Hensarling and President Trump at the signing of Trump's executive order concerning Dodd-Frank. Source: ThinkAdvisor.

“There is merit in the contention of many firms that… the Volcker rule is too complicated,” said Tarullo. “Although the evidence is still more anecdotal than systematic, it may be having a deleterious effect on market making”. Tarullo is strongly behind the rest of the act, though, and claimed “it would be a substantial over-reach to claim that the new regulatory system is broadly hamstringing either the banking system or the economy”. Rep. Maxine Waters of California, the ranking member of the House Financial Services Committee, said that she and other Democrats have always been open to making minor modifications to Dodd-Frank [10]. Nevertheless, she, like Turillo and other Democrats, stands strongly behind the bill and its effects.

Conclusion

Successfully passing any substantial revisions to Dodd-Frank will prove challenging to the Trump Administration. In order to pass any modifications for the bill through the U.S. Senate, the bill would require 60 votes. As it currently stands, there are only 52 Republican Senators and it seems unlikely that Trump could rustle up 8 extra votes, even if all Senate Republicans support it. After the Republicans’ Obamacare replacement act was defeated so soundly, this seems especially improbable. One way that Hensarling and Republicans could bypass the obstacle of the 60 Senate votes is through the budget reconciliation process. In the coming weeks, his committee has to submit its “budget views” to the House Budget Committee, where Hensarling is expected to include many of his desired reforms. The budget reconciliation bill only requires a simple majority to pass.

The Trump Administration and Congressional Republicans appear motivated to change Dodd-Frank, but it is clear Democrats are going to fight. Democrats believe the new regulations on Wall Street to be necessary to avoid another Great-Recession-like crisis. As it currently stands there is no easy strategy ahead for Republicans to reign in Dodd-Frank.

PENN WHARTON PPIRESOURCE SPOTLIGHT:

<h3>Federal Reserve Economic Data (FRED®)</h3><p><strong><img width="180" height="79" alt="" src="/live/image/gid/4/width/180/height/79/481_fred-logo.rev.1407788243.jpg" class="lw_image lw_image481 lw_align_right" data-max-w="222" data-max-h="97"/>An online database consisting of more than 72,000 economic data time series from 54 national, international, public, and private sources.</strong> FRED®, created and maintained by Research Department at the Federal Reserve Bank of St. Louis, goes far beyond simply providing data: It combines data with a powerful mix of tools that help the user understand, interact with, display, and disseminate the data.</p><p> Quick link to data page: <a href="http://research.stlouisfed.org/fred2/tags/series" target="_blank">http://research.stlouisfed.org/fred2/tags/series</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>

<h3>The Penn World Table</h3><p> The Penn World Table provides purchasing power parity and national income accounts converted to international prices for 189 countries/territories for some or all of the years 1950-2010.</p><p><a href="https://pwt.sas.upenn.edu/php_site/pwt71/pwt71_form.php" target="_blank">Quick link.</a> </p><p>See all <a href="/data-resources/">data and resources</a> »</p>

<h3>Congressional Budget Office</h3><p><img width="180" height="180" alt="" src="/live/image/gid/4/width/180/height/180/380_cbo-logo.rev.1406822035.jpg" class="lw_image lw_image380 lw_align_right" data-max-w="180" data-max-h="180"/>Since its founding in 1974, the Congressional Budget Office (CBO) has produced independent analyses of budgetary and economic issues to support the Congressional budget process.</p><p> The agency is strictly nonpartisan and conducts objective, impartial analysis, which is evident in each of the dozens of reports and hundreds of cost estimates that its economists and policy analysts produce each year. CBO does not make policy recommendations, and each report and cost estimate discloses the agency’s assumptions and methodologies. <strong>CBO provides budgetary and economic information in a variety of ways and at various points in the legislative process.</strong> Products include baseline budget projections and economic forecasts, analysis of the President’s budget, cost estimates, analysis of federal mandates, working papers, and more.</p><p> Quick link to Products page: <a href="http://www.cbo.gov/about/our-products" target="_blank">http://www.cbo.gov/about/our-products</a></p><p> Quick link to Topics: <a href="http://www.cbo.gov/topics" target="_blank">http://www.cbo.gov/topics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>

<h3>Internal Revenue Service: Tax Statistics</h3><p><img width="155" height="200" alt="" src="/live/image/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg" class="lw_image lw_image486 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg 2x" data-max-w="463" data-max-h="596"/>Find statistics on business tax, individual tax, charitable and exempt organizations, IRS operations and budget, and income (SOI), as well as statistics by form, products, publications, papers, and other IRS data.</p><p> Quick link to <strong>Tax Statistics, where you will find a wide range of tables, articles, and data</strong> that describe and measure elements of the U.S. tax system: <a href="http://www.irs.gov/uac/Tax-Stats-2" target="_blank">http://www.irs.gov/uac/Tax-Stats-2</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>

<h3>National Bureau of Economic Research (Public Use Data Archive)</h3><p><img width="180" height="43" alt="" src="/live/image/gid/4/width/180/height/43/478_nber.rev.1407530465.jpg" class="lw_image lw_image478 lw_align_right" data-max-w="329" data-max-h="79"/>Founded in 1920, the <strong>National Bureau of Economic Research</strong> is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.</p><p> Quick Link to <strong>Public Use Data Archive</strong>: <a href="http://www.nber.org/data/" target="_blank">http://www.nber.org/data/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>

<h3>National Center for Education Statistics</h3><p><strong><img width="400" height="80" alt="" src="/live/image/gid/4/width/400/height/80/479_nces.rev.1407787656.jpg" class="lw_image lw_image479 lw_align_right" data-max-w="400" data-max-h="80"/>The National Center for Education Statistics (NCES) is the primary federal entity for collecting and analyzing data related to education in the U.S. and other nations.</strong> NCES is located within the U.S. Department of Education and the Institute of Education Sciences. NCES has an extensive Statistical Standards Program that consults and advises on methodological and statistical aspects involved in the design, collection, and analysis of data collections in the Center. To learn more about the NCES, <a href="http://nces.ed.gov/about/" target="_blank">click here</a>.</p><p> ﻿Quick link to NCES Data Tools: <a href="http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4" target="_blank">http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4</a></p><p> Quick link to Quick Tables and Figures: <a href="http://nces.ed.gov/quicktables/" target="_blank">http://nces.ed.gov/quicktables/</a></p><p> Quick link to NCES Fast Facts (Note: The primary purpose of the Fast Facts website is to provide users with concise information on a range of educational issues, from early childhood to adult learning.): <a href="http://nces.ed.gov/fastfacts/" target="_blank">http://nces.ed.gov/fastfacts/#</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>